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0 R E P O R T O F T H E C O M M I T T E E O N 0
T H E
F I N A N C I A L A S P E C T S
O F
C O R P O R A T E G O V E R N A N C E
1 DE C E M B E R 1992
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0 R E P O R T O F T H E C O M M I T T E E O N 0
T H E
F I N A N C I A L A S P E C T S
OF
C O R P O R A T E G O V E R N A N C E
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0 1992 The Committee on the Financial Aspects ofCorporate Governance and Gee and Co. Ltd.
Reproduction of this publication in whole or in part is
unrestricted for internal communications within a given
organisation. It is otherwise subject to permission which
will not be refused but will attract a reasonable
reproduction charge. A leaflet is available from the
Publishers setting out full details of the level of the charge
and when it is applicable.
First published December 1992
ISBN 0 85258 913 1 (Report)
ISBN 0 85258 915 8 (R epo rt with Code of Best Practice)
Gee (a division of Professional Publishing Ltd)
South Quay Plaza
183 Marsh Wall
London El4 9FSFreephone: (0800) 289520
Fax: (071) 537-2557
Printed in Great Britain by Burgess Science Press.
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Queries and correspondence relating to the report should be
addressed to:
The Secretary
Committee on the Financial Aspects of Corporate
Governance
Up to 31 e emhe r~ 1992P.O. Box 433
Moorgate PlaceLondon EC2P 2BJTel: (07 I) 628-7060 ext.2565Fax: (071) 6281874
From Ja/rrrar~y 1 9 9 3c/o The London Stock Exchange
London EC2N IHPTel: (071) 797-4575
Fax: (071) 4.1~0:6822
Additional copies of the report may be obtained from:
Gee (a division of Professional Publishing Ltd)
South Quay Plaza
183 Marsh Wall
London El4 9FS
Freephone: (0800) 289520
Fax: (071) 537-2557
Price: IO.00 per copy, including a copy of the Code ofBest Practice.
The Code of Best Practice may also be purchased as a
separate publication, price fIlO.00 per pack of ten.
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P R E F A C E
T H E
INTRO llc N
T H E
T H E
REASONS FOR SETTING UP THE
C ORPORATE G O V E R N A N C E
REPORT CONTENT
C ODE OF B EST P R A C T I C E
C OMMITTEE
COMPANIES TO WHOM DIRECTED
CODE PRINCIPLES CiLSTATEMENT OF COMPLIANCE
KEEPING THE CODE UP TO DATE
i
C OMPLIANCE
O RD
BOARD EFFECTIVENESS
THE CHAIRMAN
NO N- EXECUTIVE DIRECTORS
PROFESSIONAL ADVICE
DIKECTORS TR ININGBOARD STRUCTURES AND PROCEDURES THE COMPANY SECRETARY
DIRECTORS' RESPONSIBILITIES
STANDARDS : CONDUCTNOMINATION COMMITTEES
INTEKN LCoNTRoLsAUDIT COMMITTEES
INTEKN LAUDITB OARD REMUNERATION
___
PAGE
9
16
.-
20
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CONTENTS
P A G E
F INANCIAL REPORTS
REPORTING PRACTICE
PENSIONS GOVERNANCE
T H E
IMPORTANCE OF AUDIT
PROFESSIONAL OBJECTIVITY
QUARANT IN ING AUDIT FROM O T H E R
ROTATION OF AUDIT ORS
36
SERVICES
W AYS TO INCREASE E FFECTIVENESS AND V ALUE OF THE A U D I T
THE EXPECTATIONS GA P _INTERNAL CONT ROL ~~~~__~GOING CONCERN
FRAUD
O THER ILLEGAL AC T S
A UDIT ORS LIABILITY
AUDIT CONFIDENCE
S H A R E H O L D E R S 48
ACCOUNTABILITY OF BOARDS TO SH AREH OL DERS
INSTITUTIONAL SHAREHOLDERS SHAREHOLDER
SHAREHOLDER
c0 NC I USI0N
COMMUNICAT IONS
INFLUENCE53
SUMMAKY ~~liCOMMENl A IONS 54
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APPENDI ES
T ERMS OFT H E C O M M I T T E ES M E M B E R S H I P A N D
R E F E R E N C E
2 T HE R OLE OF B ODIES REFERRED TO IN THE R E P O R T
3 D I R E C T O R S RESPONSIB IL ITY ST A T E M E N T
4 A UDIT C O M M I T T E E S
5 C URRENT STATUTORY AND O T H E R R E Q U I R E M E N T S
6 A U D I T O R S LI A B I L I T Y : THE C APARO C A S E
C ONTRIBUTORS AND R ELEVANT P UBL ISHED ST A T E M E N T S
CONTENTS
PAGE
61
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When our Committee was formed just over eighteen months ago,
neither our title nor our work programme seemed framed to catch
the headlines. In the event, the Committee has become the focusof far more attention than I ever envisaged when I accepted theinvitation to become its chairman. The harsh economic climate is
par t ly responsib le , s ince i t has exposed company repor ts and
a c c o u n t s t o u n u s u a l l y c l o s e s c r u t i n y . I t i s , h o w e v e r , t h e
cont inuing concern about s tandards of f inanc ia l repor t ing and
accountability, heightened by BCCI, Maxwell and the controversy
over directors pay, which has kept corporate governance in the
public eye.
Unexpected though this attention may have been, i t reflects a
climate of opinion which accepts that changes are needed and it
presents an opportunity to raise standards of which we should take
full advantage. Our draft proposals have been thoroughly aired
and have attracted a considerable weight of informed comment
from a wide range of individuals and bodies with an interest in
matters of corporate governance. While it has not been uncritical,
t h e g r e a t m a j o r i t y o f o u r r e s p o n d e n t s h a v e s u p p o r t e d t h e
Committees approach and it is this consensus which gives us a
mandate to proceed. The Committee is being looked to for a lead,which we have a duty to provide.
I wish to thank the members of the Committee for their diligence
and above all our Secretary, whose single-minded commitment to
the Committees progress has enabled us to complete the task we
were set in May of last year. The report represents a shared view
of the action which needs to be taken in the field of f inancial
reporting and accountability and it is one to which every member
of the Committee has contributed. The Committee has benefited
f r o m t h e b r e a d t h o f i t s r e p r e s e n t a t i o n , w h i c h h a s i n c l u d e d
m e m b e r s o f t h o s e b o d i e s b e s t p l a c e d t o s u p p o r t t h e
implementation of its recommendations.
would a lso l ike on beha l f o f the Commit tee to express our gratitude to everyone who has contributed to our work either by
s u b m i t t i n g e v i d e n c e 1 us directly, or through the press or byproviding platforms for debates on governance issues.
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PREFACE
Acceptance of the repor t s f ind ings wi l l mark an impor tan t
advance in the process of establishing corporate standards. Our
r e c o m m e n d a t i o n s w i l l , h o w e v e r , h a v e t o b e r e v i e w e das circumstances change and as the broader debate on governance
develops. We will continue in existence as a Committee until a
successor body -is appointed, to act as a source of authority on ourrecommendations and to review their implementation.
Adrian Cadbury
Chairman
1 December 1992
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1. 1 The countrys economy depends on the drive and efficiency
of its companies. Thus the effectiveness with which their
boards discharge their responsibilities determines Britainscompeti t ive posi t ion. They must be free to drive their
companies forward, but exercise that freedom within a
framework of effective accountability. This is the essence
of any system of good corporate governance.
1.2 The Commit tees recommendat ions are focused on the
control and reporting functions of boards, and on the role
of auditors. This reflects the Committees purpose, which
w a s t o r e v i e w t hos e a s pe c t s o f c o rpo ra t e gove rna nc e
s p e c i f i c a l l y r e l a t e d t o f i n a n c i a l r e p o r t i n g a n da c c o u n t a b i l i t y . O u r p r o p o s a l s d o , h o w e v e r , s e e k t o
contribute positively to the promotion of good corporate
governance as a whole.
1.3 At the heart of the Committees recommendations is a Code
of Best Pract ice designed to achieve the necessary high
s t a nda rds o f c o rpo ra t e be ha v i ou r . The London S t oc k
Exchange intend to require all listed companies registered
in the Uni ted Kingdom, as a cont inuing obl igat ion of
listing, to state whether they are complying with the Code
and to give reasons for any areas of non-compliance. This
requirement wil l enable shareholders to know where the
companies in which they have invested stand in relation to
the Code. The obligation will be enforced in the same way
as a l l o ther l i s t ing obl igat ions . This may include, in
appropriate cases, the publication of a formal statement of
censure.
1.4 The Committee will remain responsible for reviewing theimplementation of its proposals until a successor body is
appointed in two years time, to examine progress and to
continue the ongoing governance review. It will be for our
s pons o r s t o a g re e t he r e mi t o f t he ne w body a nd t o
es tab l i sh the bas i s o f i t s suppor t . In the meant ime . a
programme of research wil l be undertaken to assist the
future monitoring of the Code.
1.5 By adhering to the Code, listed companies will strengthen
both their control over their businesses and their publicaccountability. In so doing. they will be striking the right
b a l a n c e b e t w e e n m e e t i n g t h e s t a n da r ds o f c o r po ra t e
gove rna nc e now e xpe c t e d o f t he m a nd r e t a i n i ng t he
essential spirit of enterprise.
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THE SETTING FOR THE REPORT
1.6 Bringi ng greater clarity to the respective responsibilities of
directors, shareholders and auditors will also strengthen
trust in the corporate system. Companies whose standardsof corporate governance are high are the more l ikely to
ga in t he con f idence o f i nves to r s and suppo r t f o r t he
development of their businesses.
1.7 The basic system of corporate governance in Britain is
sound. The principles are well known and widely followed.
Indeed the Code closely ref lects exist ing best practice.
This sets the standard which all listed companies need to
match.
1.8 Our proposals aim to strengthen the unitary board system
and increase its effectiveness, not to replace it. In law. all
d i r ec to r s a r e r e spons ib l e f o r t he s t ew ar dsh ip o f t he
companys assets. All directors, therefore, whether or notthey have executive responsibilities, have a monitoring role
and are responsible for ensuring that the necessary controls
over the activities of their companies are in place - andworking.
1.9 Had a Code such as ours been in existence in the past, we
believe that a number of the recent examples of unexpected
company failures and cases of fraud would have received
attention earlier. It must, however, be recognised that no
system of control can eliminate the risk of fraud without so
shackling companies as to impede their ability to compete
in the market place.
1.10 We believe that our approach, based on compliance with a
voluntary code coupled with disclosure, wi-II prove moreeffective than a statutory code. It is directed at establishing
best practice, at encouraging pressure from shareholders to
has ten i t s widespread adopt ion , and a t a l lowing some
flexibility in implementation. We recognise, however. that
i f companies do not back our recommendat ions . i t i s
probable that legislation and external regulation will be
sought to deal with some of the underlying problems which
the report identif ies. Statutory measures would impose a
minimum standard and there would be a greater r isk of
boards complying wi th the le t te r , ra ther than wi th thespirit, of their requirements.
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THE SETTING FOR THE REPORT
1.11 The Committee is clear that action by boards of directors
a n d a u d i t o r s o n t h e f i n a n c i a l a s p e c t s o f c o r p o r a t e
governance is expected and necessary. We are encouragedby the degree to which boards are already reviewing their
s t r u c t u r e s a n d s y s t e m s i n t h e l i g h t o f o u r d r a f t
recommendations. The adoption of our recommendations
wi l l mark an important s tep forward in the cont inuing
process of ra is ing standards in corporate governance.
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INTRODUCTION
Reasons for setting up the Committee
2.1 The Committee was set up in May 1991 by the Financial
Repor t ing Counc i l , the London S tock Exchange and the
accountancy profession to address the financial aspects of
corporate governance. The Committees membership and
terms of reference are set out in Appent i r 1 I ts sponsorswere concerned at the perceived low level of conf idence
both in financial reporting and in the ability of auditors to
provide the safeguards which the users of company reports
sought and expected. The underlying factors were seen as
the looseness of account ing standards, the absence of a
c lea r f ramework for ensur ing tha t d i rec tors kept under
rev iew the cont ro ls in the i r bus iness , and compet i t ive
pressures both on companies and on auditors which made it
difficult for auditors to stand up to demanding boards.
2.2 These concerns about the working of the corporate system
were he ightened by some unexpec ted fa i lu res o f ma jor
companies and by criticisms of the lack of effective board
accountability for such matters as directors pay.. Further
evidence of the breadth of feel ing that act ion had to be
taken to clarify responsibilities and to raise standards came
from a number of reports on different aspects of corporate
governance which had either been published or were in
preparation at that time.
2.3 T h e C o m m i t t e e w h e r e v e r p o s s i b l e d r e w o n t h e s e
d o c u m e n t s , a n d a w i d e r a n g e o f s u b m i s s i o n s f r o m
interested parties, in producing its draft report which wasissued for public comment on 27 May 1992.
2.4 Since then, the Committee has received over 200 writ ten
responses to i ts proposals, the grea t ma jor i t y o f wh ich
b r o a d l y s u p p o r t t h e C o m m i t t e e s a p p r o a c h , a n d h a s
carefully considered the balance of opinions expressed on
part icular issues. The Committee is most grateful to al l
those who have taken the time and trouble to give us their
comments. They have helped to shape our final report and,
in addit ion, they are a valuable reference source for oursuccessors. A list of contributors and of relevant published
statements appears in Appcndis 7.
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. . . . .I ~.~... ..... .. ...~. I
INTRODUCTION
Corporate Governance
2.5 Corporate governance is the system by which companiesa re d i r e c t e d a nd c on t ro l l e d . Boa rds o f d i r e c t o r s a r e
responsible for the governance of their companies. The
shareholders role in governance is to appoint the directors
a n d t h e a u d i t o r s a n d t o s a t i s f y t h e m s e l v e s t h a t a n
a p p r o p r i a t e g o v e r n a n c e s t r u c t u r e i s i n p l a c e . T h e
responsibilities of the board include setting the companys
strategic aims, providing the leadership to put them into
effect , supervising the management of the business and
reporting to shareholders on their stewardship. The boards
a c t i o n s a r e s u b j e c t t o l a w s , r e g u l a t i o n s a n d t h e
shareholders in general meeting.
2.6 Within that overal l framework, the specifical ly f inancial
aspects of corporat: governance ih Committees remit)a re the way in which boards se t f inanc ia l po l i cy and
oversee its implementation, including the use of financial
c o nt r ol s , and the proces: whereby they repor t on theactivities and progress of the company to the shareholders.
2.7 The role of the auditors is to provide the shareholders with
an external and objective check on the directors financial
statements which form the basis of that reporting system.
Although the reports of the directors are addressed to the
shareholders, they are important to a wider audience, not
least to employees whose interests boards have a statutory
duty to take into account.
2.8 The Committees objective is to help to raise the standards
of corporate governance and the level of confidence infinancial reporting and auditing by setting out clearly what
it sees as the respective responsibilities of those involved
and what it believes is expected of them.
Report Content
2.9 T h e r e p o r t b e g i n s b y r e v i e w i n g t h e s t r u c t u r e a n d
respons ib i l i t i e s of boards of d i rec tors ; here we have
s umma r i s e d ou r r e c omme nda t i ons i n a Code o f Be s t
Practice. Next, we consider the role of auditors and addressa n u m b e r o f r e c o m m e n d a t i o n s t o t h e a c c o u n t a n c y
p r o f e s s i o n . W e t h e n d e a l w i t h the r i g h t s and
responsibilities of shareholders. The report concludes with
several appendices, including at Appendix 2 notes on the
roles of some of the bodies referred to in the report.
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Companies to whom directed
3.1 The Code of Best Practice (on pages 58 to 60) is directedto the boards of directors of all listed companies registered
i n t h e U K , b u t w e w o u l d e n c o u r a g e a s m a n y o t h e r
companies as possible to aim at meeting its requirements.
Code Principles
3.2
3.3
3.4
3.5
3.6
The principles on which the Code is based are those of
openness, integrity and accountabil ity. They go together.
Openness on the part of companies, within the limits set by
their competitive position, is the basis for the confidence
which needs to exist between business and all those who
have a s t ake in i t s success . An open approach to the
d i s c l o s u r e o f i n f o r m a t i o n c o n t r i b u t e s t o t h e e f f i c i e n t
working of the market economy, prompis boards to takeef fec t ive ac t ion and a l lows shareholders and o thers to
scrutinise companies more thoroughly.
I n t e g r i t y m e a n s b o t h s t r a i g h t f o r w a r d d e a l i n g a n dcompteteness. What is required of f inancial report ing istha t i t should be hones t and th~at i t should presen t a
balanced picture of the state of the companys affai rs . The
integrity of reports depends on the integrity of those who
prepare and present them.
Boards of directors are accountable to their shareholders
a n d b o t h h a v e t o p l a y t h e i r p a r t i n m a k i n g t h a t
accountability effective. Boards of directors need to do so
through the quality of the information which they provide
to shareholders, and shareholders through the.ir willingnessto exercise their responsibilities as owners.
The arguments for adhering to the Code are twofold. First,a c lea r unders tanding of respons ib i l i t i e s and an open
approach to the way in which they have been discharged
wi l l a s s i s t boards of d i rec tors in f raming and winning
support for their strategies. It will also assist the efficient
operat ion of capital markets and increase confidence in
boards , audi tors and f inanc ia l repor t ing and hence the
general level of confidence in business.
Second, if standards of financial reporting and of business
conduct more generally are not seen to be raised, a greater
re l i ance on regula t ion may be inevi t ab le . Any fur the r
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THE CODE OF BEST PRACTICE
degree of regulation would, in any event, be more likely to
be well directed, if it were to enforce what has already
been shown to be workable and effective by those settingthe standard.
Statement of Compliance
3.7 We recommend that listed companies reporting in respect
of years ending af ter 30 June 1993 should state in thereport and accounts whether they comply with the Code and
identify and give reasons for any areas of non-compliance.
The London Stock Exchange in tends to require such a
statement as one of its continuing listing obligations.
3.8 We envisage, however, that many companies will wish to
go beyond the strict terms of the London Stock Exchange
rule and make a general s ta tement about the corporate
governance of their enterprises as some leading companies
have already done. We welcome such statements and leave
it to boards to decide the terms in which they make their
s t a t emen t o f compl i ance . Boar ds a r e no t expec t ed to
comment separately on each item of the Code witti whichthey are complying, but areas of non-compliance will haveto be dealt with individually.
3.9 The continuing obligations laid down by the London StockE x c h a n g e s h o u l d r e q u i r e c o m p a n i e s s t a t e m e n t s o f
compliance to have been the subject of review by the
auditors before publication. The review should cover only
those parts of the compliance statement which relate to
p r o v i s i o n s o f t h e C o d e w h e r e c o m p l i a n c e c a n b e
ob jec t ive ly ve r i f i ed ( s ee f oo tno te t o t he Code) . T heaud i to r s shou ld no t be r equ i r ed to r epo r t f o r ma l ly a
satisfactory conclusion to their review, but if they identify
an area of non-compliance which is not properly disclosed,
they should draw attention to i t in their report on the
f inancia l s ta tements . We r e c o m m e n d that the Audi t ing
Prac t ices Board should cons ider gu idance fo r aud i to r s
accordingly
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THE CODE OF BEST PRACTICE
3.10 The Code is to be followed by individuals and companies in
the light of their own particular circumstances. They arc
responsible for ensuring that their actions meet the spirit ofthe Code and in interpreting it they should give precedence
to substance over form.
Keeping the Code up to date
3.11 We have addressed those issues which appeared from the
evidence before us to require the most immediate attention.
The s i tuat ion , however , i s developing. The Account ing
Standards Board has in hand a programme of work on the
basis cf financial reporting. Revised accounting standardsand improved methods of financial presentation will result.
At the same time, views on best boardroom practice will
evolve in the light of experience, and European Community
directives and regulations may give rise to new issues. It is
esse nt ia l , there fore , that the Code, in addi t ion to being
monitored, is kept up to date.
3 . 1 2 W e r e c o m m e n d t h a t o u r s p o n s o r s , c o n v e n e d b y t h e
F i n a n c i a l R e p o r t i n g C o u n c i l , s h o u l d a p p o i n t a n e w
Committee by the end of June 1995 to examine how farcompliance with the Code has progressed, how far our
o t h e r r e c o m m e n d a t i o n s h a v e b e e n i m p l e m e n t e d , a n d
whether the Code needs updating in l ine with emerging
issues. Our sponsors should also determine whether the
sponsorship of the new Committee should be broadened and
whether wider matters of corporate governance should be
i n c l u d ed i n i t s b r i e f . In t h e m e a n t i m e , t h e p r e s e n tC o mmi t t ee w i l l r ema i n r e sp o n s i b l e f o r r ev i ew i n g t h e
implementation of its proposals and for identifying further
issues which its successor body might usefully consider.
T h e s e s t e p s w i l l e s t a b l i s h a c o n t i n u i n g p r o c e s s .ofgovernance review.
Compliance
3.13
3.14
R ai s i n g s t an d a r d s o f co r p o r a t e g o v e r n an ce can n o t b e
achieved by structures and rules alone. They are important
because they provide a framework which will encourage
and support good governance, but what counts is the way inwhich they are put to use.
The responsibility for putting the Code into practice lies
directly with the boards of directors of listed companies to
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THE CODE OF BEST PRACTICE
w h o m i t i s a d d r e s s e d . C o m p l i a n c e i t s e l f , h o w e v e r , i s a
m a t te r f o r ev e r y one c onc e r ned w i t h c o r po r a te gov e r nanc e .
We look to the f inanc ia l ins t i tu t ions and the w ide range of bodies back ing our work to encourage the adopt ion of our
r e c o m m e n d a t i o n s b y c o m p a n i e s i n w h i c h t h e y h a v e a n
i n te r es t . T he m ed i a a l s o hav e a pa r t t o p l ay i n d r aw i ng
a t t e n t i o n t o g o v e r n a n c e i s s u e s o f p u b l i c o r s h a r e h o l d e r
concern. I t i s v i ta l to se ize the oppor tuni ty presented by a
c l imate of opin ion which accepts that changes are needed
and which is expecting the Committee to give the necessary
lead.
3 . 1 5 T h e C o m m i t t e e r e c o g n i s e s t h a t s m a l l e r l i s t e d c o m p a n i e s
m a y i n i t i a l l y h a v e d i f f i c u l t y i n c o m p l y i n g w i t h s o m e
a s p e c t s o f t h e C o d e a n d w e h a v e g i v e n c a r e f u l
c ons i de r a t i on t o t he r es pons es t o t he d r a f t r epo r t w h i c h
a d d r e s s e d t h i s p o i n t . T h e b o a r d s o f s m a t t e r l i s t e d
c o m p a n i e s w h o c a n n o t , f o r t h e t i m e b e i n g , c o m p l y w i t h
par ts of the Code should note that they may ins tead g ive
the i r r eas ons ftir n o n - c o m p l i a n c e . W e b e l i e v e , h o w e v e r ,t h a t full c o m p l i a n c e w i l l b r i n g b e n e f i t s t o t h e b o a r d s o f such companies and i t should be thei r ob jec t ive to ensure
t h a t t h e b e n e f i t s a r e a c h i e v e d . I n p a r t i c u l a r , t h e
appo i n tm en t o f app r op r i a te non - ex ec u t i v e d i r ec to r s s hou l d
m ak e a pos i t i v e c on t r i bu t i on t o t he dev e l opm en t o f t he i r
businesses. Any practical issues which may arise in respect
of smat ter l i s ted companies w i l t be thoroughly rev iewed by
the Committee and i ts successor.
3 . 1 6 T h e C o m m i t t e e n o t e s t h a t c o m p a n i e s w i l l n o t b e a b l e t o
c o m p l y w i t h i t e m s 4 . 5 a n d 4 . 6 i n t h e C o d e u n t i l t h e
necessary guidance for companies has been developed.
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Board Effectiveness
4.1 Every public company should be headed by an effectiveboard which can both lead and control the business . Within
the context of the UK unitary board system, this means a
board made up of a combination of executive directors,
with their in t imate knowledge of the business , and of
outside, non-executive directors, who can bring a broader
view to the companys activit ies, under a chairman who
accep ts the du t ies and respons ib i l i t i es which the pos t
entails.
4.2 Tests of board effectiveness include the way in which themember,s of the board as a whole work together under thec ha i r ma n , w ho se r o l e i n c o r po ra t e g ov er na nc e is
fundamental , and their collective abil i ty to provide both
the leadership and the checks and balances which effectivegovernance demands. Shareholders are responsible for
electing board members and it is in their interests to see
that the boards of their companies are properly constituted
and not dominated by any one individual.
4.3 All directors are equally responsible in law for the boards
a c t i o n s a n d d e c i s i o n s . C e r t a i n d i r e c t o r s m a y h a v e
particular responsibil i t ies, as executive or non-executive
directors, for which they are accountable to the board.
Regardless of specif ic dut ies under taken by individual
directors, however, it is for the board collectively to ensure
that it is meeting its obligations.
4.4 W hi ls t i t i s t he bo ar d a s a wh ol e w hi ch is th e f in al
authority, executive and non-executive directors are likelyto contribute in different ways to its work. Non-executive
directors have two particularly important contributions to
make to the governance process as a consequence of their
independence from executive responsibility. Neither is in
conflict with the unitary nature of the board.
4.5 The first is in reviewing the performance of the board and
of the executive. Non-executive directors should address
this aspect of their responsibil i t ies carefully and should
ensure that the chairman is aware of their views. If thechairman is also the chief executive, board members should
look to a senior non-executive director, who might be the
deputy chairman, as the person to whom they should
a d d r e s s a n y c o n c e r n s a b o u t t h e c o m b i n e d o f f i c e o f
cha i rman/ch ief execu t ive and i t s consequences fo r the
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ef fect iveness of the board. A number of companies have
recognised that ro le and some have done so formal ly in
their Articles.
4.6 The second is in taking the lead where potential conflicts
of interest arise. An important aspect of effective corporate
governance is the recognition that the specific interests of
the execut ive management and the wider interests of the
company may at times diverge, for example over takeovers,
boardroom succession, or directors pay. Independent non-
e x e c u t i v e d i r e c t o r s , w h o s e i n t e r e s t s a r e l e s s d i r e c t l y
affected, are well-placed to help to resolve such situations.
The Chairman
4.7 The chairmans role in securing good corporate governance
i s c r u c i a l . C h a i r m e n a r e p r i m a r i l y r e s p o n s i b l e f o r t h e
working of the board, for its balance of membership subject
to board and shareholders approval, for ensuring that all
relevant issues are on the agenda, and for ensuring that all
d irectors, execut ive and non-execut ive al ike, are enabled
and encouraged to p lay the i r fu l l par t in i ts act iv i t ies .
Chairmen should be able to stand sufficiently back from the
day- to -day running o f the business to ensure that the i r
boards are in full control of the companys affairs and alert
to their obligations to their shareholders.
4.8 It is for chairmen to make certain that their non-executive
directors receive t imely, relevant informat ion tai lored to
their needs, that they are properly br iefed on the issues
arising at board meetings, and that they make an effective
contribution as board members in practice. It is equally forchairmen to ensure that execut ive directors look beyond
thei r execut ive dut ies and accept the i r fu l l share o f the
responsibilit ies of governance.
4.9 G i v e n t h e i m p o r t a n c e a n d p a r t i c u l a r n a t u r e o f t h e
chairmans role, it should in principle be separate from that
of the chief executive. If the two roles are combined in one
person, it represents a considerable concentration of power.
We recommend, therefore, that there should be a clear ly
a c c e p t e d d i v i s i o n o f r e s p o n s i b i l i t i e s a t t h e h e a d o f ac o m p a n y , w h i c h w i l l e n s u r e a b a l a n c e o f p o w e r a n d
a u t h o r i t y , s u c h t h a t n o o n e i n d i v i d u a l h a s u n f e t t e r e d
powers of decision. Where the chairman is also the chief
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executive, it is essential that there should be a strong and
independent element on the board.
Non-Executive Directors
4 . 1 0 The Commi t t e e be l i e ve s t ha t t he c a l i b r e o f t he non-executive members of the board is of special importance in
setting and maintaining standards of corporate governance.
The emphasis in this report on the control function of non-
execut ive di rec tors i s a consequence of our remit and
s hou l d no t i n a ny w a y de t r a c t f rom t he p r i ma ry a nd
positive contribution which they are expected to make, as
equal board members, to the leadership of the company.
4.11 N o n- e xe c u t i ve d i r e c t o r s s h ou l d b r i n g a n i nd e pe n de n t
judgement to bear on issues of s t ra tegy, per formance,
resources, including key appointments , and s tandards of
conduct . We recommend that the cal ibre and number of
non-executive directors on a board should be such that
their views wil l carry s ignificant weight in the boards
d e c i s i o n s . T o m e e t o u r r e c o m m e n d a t i o n s o n t h e
composition of sub-committees of the board, all boards will
require a minimum of three non-executive directors, one of
whom may be the chairman of the company provided he or
she is not also its executive head. Additionally, two of the
three should be independent in the terms set out in the next
paragraph.
4.12 An essential quali ty which non-executive directors should
bring to the boards deliberations is that of independence
of judgement. We recommend that the majori ty of non-
e xe c u t i ve s on a boa rd s hou l d be independent o f thecompany. This means that apart from their directors fees
a n d s h a r e h o l d i n g s , t h e y s h o u l d b e i n d e p e n d e n t . o f
m a n a g e m e n t a n d f r e e f r o m a n y b u s i n e s s o r o t h e r
re la t ionship which could mater ia l ly interfere wi th the
exercise of their independent judgement. It is for the board
to decide in particular cases whether this definition is met.
Information about the relevant interests of directors should
be di sclosed in the Directors Repor t.
4 .13 O n fe e s , t h e r e i s a b a l a n c e t o b e s t r u c k b e t w e e nrecognising the value of the contribution made by non-
e x e c u t i v e d i r e c t o r s a n d n o t u n d e r m i n i n g t h e i r
independence. The demands which are now being made on
conscientious non-executive directors are s ignificant and
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4.14
4.15
4.16
4.17
their fees should reflect the time which they devote to the
companys affairs. There is, therefore, a case for paying for
a d d i t i o n a l r e s p o n s i b i l i t i e s t a k e n o n , f o r e x a m p l e , b y
chairmen of board committees. In order to safeguard their
independent pos i t ion , we regard i t as good pract ice for
non-executive directors not to participate in share option
schemes and for their service as non-executive directors
not to be pensionable by the company.
Non-executive directors lack the inside knowledge of the
company of the executive directors, but have the same right
of access to information as they do. Their effectiveness
t u r n s t o a c o n s i d e r a b l e e x t e n t o n t h e q u a l i t y o f t h e
information which they receive and on the use which they
make of it. Boards should regularly review the form and the
extent of the information which is provided to all directors.
Given the importance of their distinctive contribution, non-
e x e c u t i v e d i r e c t o r s s h o u l d b e s e l e c t e d w i t h t h e s a m e
impartiality and care as senior executives. We recommend
that their appointment should be a matter for the board as awhole and that there should be a formal selection process,
which wi l l re in force the independence of non-execut ive
directors and make it evident that they have been appointed
on merit and not through any form of patronage. We regard
it as good practice for a nomination committee (dealt with
be low) to car ry out the se lec t ion process and to make
proposals to the board.
Companies have to be able to bring about changes in the
composition of their boards to maintain their vitality. Non-
e xe c u t i v e d i r e c to rs m a y l o s e s o m e t h i n g o f t h e i r
independent edge , i f they remain on a board too long.
Fur thermore , the make-up of a board needs to change in
l ine with new challenges. We recommend, therefore, that
non-executive directors should be appointed for specif ied
terms. Their Letter of Appointment should set out their
d u t i e s , t e r m o f o f f i c e , r e m u n e r a t i o n a n d i t s r e v i e w .
Reappointment should not be automatic, but a conscious
decision by the board and the director concerned.
Our emphas is on the qua l i t ies to be looked fo r in non-executive directors, combined with the greater demands
now being made on them, raises the question of whether the
supply of non-executive directors will be adequate to meet
the demand. When companies encourage their executive
directors to accept appointments on the hoards of 0th;~
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companies, the companies and the individuals concerned all
gain. A policy of promoting this kind of appointment will
inc rease the pool of po ten t i a l non-execut ive d i rec tors ,particularly if the divisional directors of larger companies
are considered for non-executive posts , as well as their
main board colleagues.
Professional Advice
4.18 Occasions may arise when directors have to seek legal or
f inancial advice in the furtherance of their duties . They
should always be able to consult the companys advisers.
If, however, they consider it necessary to take independent
professional advice, we r e c o m m e n d that they should be
enti t led to do so at the companys expense, through an
agreed procedure laid down formally, for example in a
B o a r d Resolutiot;, in the Art icles , or in the Letter ofAppointment.
Directors Training
4.19 The weight of responsibility carried by all directors and thei n c r e a s i n g c o m m i t m e n t w h i c h t h e i r d u t i e s r e q u i r e
emphasise the importance of the way in which they prepare
themselves for their posts. Given the varying backgrounds,
qua l i f i ca t ions and exper ience of d i rec tors , i t i s h igh ly
des i rab le tha t they should a l l under take some form of
internal or external training; this is particularly important
for directors, whether executive or non-executive, with no
p r e v i o u s b o a r d e x p e r i e n c e . N e w l y - a p p o i n t e d b o a r d
members are also enti t led to expect a prope,r process ofinduc t ion in to the companys a f fa i r s . I t is then u p t oindividual directors to keep abreast of their legislative and
broader responsibilities.
4.20 There are already courses for newly-appointed directors run
by the Inst itute of Directors and bus iness school s. With the
suppor t o f the Bank of England , the Confedera t ion of
British Industry, the Institute of Directors, and PRO NED,
a new c o u r s e c o v e r i n g t h e f u l l r a n g e o f b o a r d
respons ib i l i t i e s wi l l be open to d i rec tors shor t ly . The
training and development of directors is of importance to
good governance and i t is one of the issues which we
suggest our successor body should keep under review.
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T HE BOARD
Board Structures and Procedures
4.21 The effectiveness of a board is buttressed by its structure
and procedures. One aspect of structure is the appointment
of committees of the board, such as the audit, remuneration
and nomination committees, referred to later in the report.
4.22 Another is that boards should recognise the importance of
t h e f i n a n c e f u n c t i o n b y m a k i n g i t t h e d e s i g n a t e d
responsibility of a main board director, who should be a
s ignatory to the accounts on behalf of the board, and
should have the right of access to the Audit Committee.
4 . 2 3 T h e b a s i c p ro c e d u ra l r e q u i r e me n t s a r e t h a t t h e b o a rd
should meet regularly, with due notice of the issues to be
d i s c u s s e d s u p p o r t e d b y t h e n e c e s s a ry p a p e rw o rk , a n d
should record its conclusions. We recommend that boards
should have a formal schedule of mat ters speci f ica l ly
reserved to them for their collective decision, to ensure
tha t the di rec t ion and control of the company remains
f i r m l y i n t h e i r h a n d s a n d a s a- s a f e g u a r d a g a i n s tmisjudgements and possible illegal practices. A schedule of
these matters should be given to directors on appointmentand should be kept up to date.
4.24 We envisage that such a schedule would at least include:
(a) acquisition and disposal of assets of the company or
its subsidiaries that are material to the company;
(b) investments, capital projects, authority levels, treasury
policies , and risk management policies.
Boards should lay down rules to determinematerial,ity
fora n y t r a n s a c t i o n , a n d s h o u l d e s t a b l i s h c l e a r l y w h i c h
transact ions require mul t ip le board s ignatures . Boards
should also agree the procedures to be followed when,
e x c e p t i o n a l l y , d e c i s i o n s a r e r e q u i r e d b e t w e e n b o a r d
meetings.
The Company Secretary
4.25 The company secretary has a key role to play in ensuring
that board procedures are both fol lowed and regular lyreviewed. The chairman and the board will look to the
company secretary f o r g u i d a n c e o n what the ir
responsibilities are under the rules and regulations to
which they are subject and on how those responsibilities
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THE BOARD
4.26
4.27
should be discharged. All directors should have access to
the advice and se rv ices of the company sec re ta ry and
should recognise that the chairman is entitled to the strong
and positive support of the company secretary in ensuring
t he e f f e c t i ve func t i on i ng o f t he boa rd . I t s hou l d be
standard practice for the company secretary to administer,
attend and prepare minutes of board proceedings.
Under the Companies Act the directors have a duty to
appoint as secretary someone who is capable of carrying
out the duties which the post entails. The responsibility for
e ns u r i ng t ha t t he s e c re t a ry r e ma i ns c a pa b l e , a nd a ny
question of the secretarys removal, should be a matter forthe board as a whole.
The Committee expects that the company secretary will be
a source of advice to the chairman and to the board on the
implementation of the Code of Best Practice.
Directors Responsibilities
4 . 2 8 S o t h a t shareholders a r e c l e a r w h e r e t h e b o u n d a r i e sb e t w e e n t h e d u t i e s o f d i r e c t o r s a n d a u d i t o r s l i e , w er e c o m m e n d t h a t a b r i e f s t a t e m e n t o f d i r e c t o r s
responsibilities for the accounts should appear in the report
and accounts , a s a counte rpar t to a s t a tement by the
auditors about their reporting responsibilities. The ground
which would need to be covered by the directors statement
is set out in A p p e n d i x 3. The appropriate position for the
d i rec tors s tatement is immediately before the auditors
report, which in future will include a
responsibilities. The two statements
each other.
statement of auditors
will thus. complement
Standards of Conduct
4.29 It i s i mpor t a n t t ha t a l l e mpl oye e s s hou l d know w ha tstandards of conduct are expected of them. We regard it as
good practice for boards of directors to draw up codes of
ethics or s tatements of business pract ice and to publish
them both internally and externally.
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Nomination Committees
4.30 One approach to making board appointments. which makesclear how these appointments are made and assists boards
in making them, is through the setting up of a nomination
commit tee , wi th the responsib i l i ty o f proposing to the
board, in the first instance, any new appointments, whether
of executive or of non-executive directors. A nomination
c o m m i t t e e s h o u l d h a v e a m a j o r i t y o f n o n - e x e c u t i v e
directors on it and be chaired either by the chairman or a
non-executive director.
internal Controls
4.31
4.32
Directors are responsible under s.221 of the Companies Act1985 for maintaining adequate accounting records. To meetthese responsibilities directors need in practice to maintain
a system of internal control over the financial management
of the company, including procedures designed to minimise
the r isk of f raud. There is, therefore, already an impl ici t
requirement on directors to ensure that a proper system of
internal control is in place.
Since an effective internal control system is a key aspect of
the efficient management of a company, we r e c o m m e n d
that the directors should make a statement in the report and
accounts on the effect iveness of their system of internal
control and that the auditors shoul~d report thereon. Thec r i t e r i a f o r a s s e s s i n g e f f e c t i v e n e s s a n d t h e d e t a i l e d
guidance for auditors will need to be established and our
recommendation to this effect is in paragraph 5.16.
Audit Committees
4.33 Since 1978, the New York Stock Exchange has required alllisted companies to have audit committees composed solely
o f i n d e p e n d e n t d i r e c t o r s a n d t h e 1987 r e p o r t o f t h eA m e r i c a n Treadway C o m m i s s i o n c o n c l u d e d t h a t a u d i tcommit tees had a cr i t ica l ro le to p lay in ensur ing the
i n t e g r i t y o f U S c o m p a n y f i n a n c i a l r e p o r t s . W h i l e
experience of audit committees in this country is shorter, it
is encouraging, and around two-thirds of the top 250 UKlisted companies now have them in place.
4.34 Experience in the United States has shown that, even where
audit committees might have been set up mainly to meet
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THE BOARD
l is t ing requi rements , they have proved the i r wor th and
d e v e l o p e d i n t o e s s e n t i a l c o m m i t t e e s o f t h e b o a r d .
S i m i l a r l y , r ec en t ly p ub l i sh ed r es ea rc h in t he U ni t ed
Kingdom concludes that the majority of companies with
audit committees are enthusiastic about their value to their
businesses. They offer added assurance to the shareholders
that the auditors, who act on their behalf, are in a position
to safeguard their interests.
4 . 3 5 T h e C o m m i t t e e t h e r e f o r e r e c o m m e n d s t h a t a l l l i s t e d
companies should establish an audit committee. Our further
recommendations on audit committees are as follows:
(a ) Audi t commit tees should be formal ly const i tuted to
ensure that they have a c lear re la t ionship wi th the
boards to whom they are answerable and to whom they
shnuld report regular ly . They shou_fd be given wri t tenterms of reference which deal adequately with their
m e m b e r s h i p , a u t ho r i ty an d du t i es , an d th e y s h o ul d
normally meet at least twice a year.
b) There s h o u l d b e a m i n i m u m o f t h r e e m e m b e r s .Membership should be confined to the non-executivedirectors of the company and a major i ty of the non-
e x e c u t i v e s s e r v i n g o n t h e c o m m i t t e e s h o u l d b e
i n d e p e n d e n t , a s de f in e d i n pa r ag r ap h 4. 1 2 a bo v e.
Membership of the committee should be disclosed in
the annual report.
c l T h e e x t e r n a l a u d i t o r s h o u l d n o r m a l l y a t t e n d a u d i tcommittee meetings, as should the finance director. As
the board as a whole is responsible for the financial
statements, other board members should also have ther i gh t t o a t t e n d . T h e c o m m i t t ee s ho u l d h a v e a
discussion with the external auditors, at least once a
y e a r , wi thout execut ive board members present , toensure that there are no unresolved issues of concern.
(d) The audit committee should have explicit authority to
investigate any matters within its terms of reference,
the resources which it needs to do so, and full access
to information. The committee should be able to obtain
external professional advice and to invite outsiderswith relevant experience to attend if necessary.
(e) The audit committees duties should be determined in
the light of the companys needs but should normally
include:
( i ) m a k i n g r e c o m m e n d a t i o n s t o t h e b o a r d o n t h e
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( )
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4 . 3 7 T h e C o m m i t t e e t h e r e f o r e r e g a r d s t h e a p p o i n t m e n t o f properly constituted audit committees as an important step
i n r a i s i n g s t a n d a r d s o f c o r p o r a t e g o v e r n a n c e . T h e i r
effectiveness depends on their having a strong chairman
who has the confidence of the board and of the auditors,
a n d o n t h e q u a l i t y o f t h e n o n - e x e c u t i v e d i r e c t o r s .
Membership of an audit committee is a demanding task
requir ing commitment, training and skil l . The directors
concerned need to have suff icient understanding of the
issues to be dealt with by the committee to take an active
part in its proceedings. This is why committees should, if it
is appropriate and within their authority, be able to inviteoutsiders with relevant experience to attend meetings.
4 . 3 8 T h e e x t e r n a l a u d i t o r s s h o u l d b e p r e s e n t a t t h e b o a r d
meeting when the annual report and accounts are approved
and preferably when the half-yearly report is considered as
well.
Internal Audit
4.39 The function of the internal auditors is complementary to,but dif fe rent from, that of the outside auditors . We regard
it as good practice for companies to establish internal audit
functions to undertake regular monitoring of key controls
and procedures. Such regular monitoring is an integral part
of a companys system of internal control and helps to
ensure its effectiveness. An internal audit function is well
placed to undertake investigations on behalf of the audit
committee and to follow up any suspicion of fraud. It is
e s s e n t i a l t h a t h e a d s o f i n t e r n a l a u d i t s h o u l d h a v eunrestricted access to the chairman of the audit committee
in order to ensure the independence of their position.
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Board Remuneration
4.40 The overriding principle in respect of board remuneration
is that of openness. Shareholders are entitled to a full and
clear statement of directors present and future benefits,
and of how they have been determined. We r e c o m m e n d
that in disclosing directors total emoluments and those of
the chairman and highest-paid UK director, separate figures
should be given for their salary and performance-related
elements and that the cri teria on which performance is
measured should be explained. Relevant information about
s t o c k o p t i o n s , s t o c k a p p re c i a t i o n r i g h t s , a n d p e n s io n
contributions should also be given.
4.41 In addition, we r e c o m m e n d that future service contracts
s h o u ld n o t e x c e e d t h r e e y e a r s w i th o u t s h a re h o ld e r s
approval and that the Companies Act should be amended in
l ine wi th th is recommendat ion. This would s t rengthen
shareholder control over levels of compensation for loss of
office.
4 . 4 2 W e a l s o r e c o m m e n d t h a t b o a r d s s h o u l d a p p o i n t
remuneration committees, consisting wholly or mainly of
non-executive directors and chaired by a non-executive
director, to recommend to the board the remuneration of
the executive directors in all its forms, drawing on outside
advice as necessary. Executive directors should play no
part in decisions on their own remuneration. Membership
o f t h e r e mu n e ra t i o n c o mmi t t e e s h o u ld a p p e a r i n t h e
Directors Report. Best practice in this field is set out in
PRO NEDs Remuneration Committee guidelines, published
in 1992.
4 . 4 3 T h e C o m m i t t e e h a s r e c e i v e d p r o p o s a l s f o r g i v i n g
shareholders the opportunity to determine matters such as
directors pay at general meetings, but does not see how
these suggestions could be made workable. A directors
remuneration is not a matter which can be sensibly reduced
to a vote for or against; were the vote to go against a
part icular remunerat ion package, the board would st il l have
to determine the remuneration of the director concerned. In
addition, there are such practical considerations as the need
to agree directors remuneration on appointment.
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4 . 4 4 S h a r e h o l d e r s r e q u i r e t h a t t h e r e m u n e r a t i o n o f d i r e c t o r s
shou ld be bo th fa i r and compe t i t i ve . S t r i k i ng th i s ba lance
i n v o l v e s d e t a i l e d c o n s i d e r a t i o n o f t h e k i n d w h i c h a
remunerat ion commit tee, whose members have no personal
i n t e r e s t i n t h e o u t c o m e , c a n g i v e t o t h e m a t t e r .
Remunerat ion commit tees need to have the in terests o f the
company and the shareholders a lways in mind in coming to
the i r dec i s i ons and the cha i rman o f t he commi t tee shou ld
be avai lab le to respond to any concerns of shareholders a t
the Annual Genera l Meet ing.
4 . 4 5 T h e A n n u a l G e n e r a l M e e t i n g p r o v i d e s t h e o p p o r t u n i t y f o r
s h a r e h o l d e r s t o m a k e t h e i r v i e w s o n s u c h m a t t e r s a s
d i r e c t o r s b e n e f i t s k n o w n t o t h e i r b o a r d s . I t i s t h e
C o m m i t t e e s v i e w t h a t s h a r e h o l d e r s c a n p l a y a m o r e
oractical g o v e r n a n c e r o l e b y a i m i n g t o i n f l u e n c e b o a r dpol ic ies in th is way, than by seeking to make the deta i l o f
board decisions subject to their vote.
4 . 4 6 F u r t h e r c h a n g e s t o t h e r u l e s f o r d i s c l o s u r e , s u c h a s
l e n g t h e n i n g t h e l i s t o f d i r e c t o r s w h o s e r e m u n e r a t i o n i s
i n d i v i d u a l l y i d e n t i f i e d , a n d t h e r o l e w h i c h s h a r e h o l d e r sc o u l d p l a y , e i t h e r i n v o t i n g o n p a r t i c u l a r a s p e c t s o f
remunerat ion or in tab l ing advisory reso lu t ions a long l ines
now developing in the USA, wil l need to be reviewed in the
l i g h t o f e x p e r i e n c e . D i r e c t o r s c o n t r a c t s a n d p a y a r e
aspec ts o f boa rd accoun tab i l i t y wh i ch the Commi t tee w i l l
cont inue to moni tor in the expectat ion that they wi l l be on
the agenda of our successor body.
Financial Reports
4.47 A b a s i c w e a k n e s s i n t h e c u r r e n t s y s t e m o f f i n a n c i a lr e p o r t i n g i s t h e p o s s i b i l i t y o f d i f f e r e n t a c c o u n t i n g
treatments be ing appl ied to essentially the same facts, wi ththe consequence that d i f ferent resu l ts or f inancia l posi t ions
c o u l d b e r e p o r t e d , e a c h a p p a r e n t l y c o m p l y i n g w i t h t h e
o v e r r i d i n g r e q u i r e m e n t t o s h o w a t r u e a n d f a i r v i e w .
Regardless o f h o w f a r t h e m a r k e t c a n u n d e r s t a n d t h ei m p l i c a t i o n s o f a l t e r n a t i v e a cc ou nt in g t r ea tm en ts o r s e e
t h r o u g h p r e s e n t a t i o n a l t e c h n i q u e s d e s i g n e d t o s h o w a
c o m p a n y s f i g u r e s i n t h e m o s t f l a t t e r i n g l i g h t , t h e r e a r e
advantages to investors, analysts, other accounts users and
ul t imate ly to the company i tse l f in f inancia l repor t ing ru les
which l imi t the scope for uncer ta in ty and manipu la t ion.
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4.48
4.49
4.50
4.5 1
4.52
4.53
THE BOARD
The lifeblood of markets is information and barriers to the
flow of relevant information represent imperfections in the
market. The need to sift and correct the information put outby companies adds cost and uncertainty to the markets
pr ic ing funct ion. The more the ac tivit ies of companies are
transparent , the more accurately wil l their securi t ies be
valued.
In addition, the wider the scope for alternative treatments,
t h e l e s s u s e fu l f i n a n c i a l r e p o r t s b e c o me in t e rms o f
comparability - over time and between companies.What shareholders (and others) need from the report andaccounts is a coherent narrative, supported by the figures,
o f t h e c o m p a n y s p e r f o r m a n c e a n d p r o s p e c t s . W e
recommend that boards should pay particular attention to
th e i r d u ty t o p r e s e n t a b a l a n c e , : a n d u n d e r s t a n d a b l e
assessment of their companys position. Balance requires
that setbacks should be dealt with as well as successes,
while the need for the report to be readily understood
emphasises that words are as important as figures.
The cardinal principle of f inancial report ing is that theview presented should be true and fair. Further principles
a re t h a t b o a rd s s h o u ld a im fo r t h e h ig h e s t l e v e l o f
d i sc losure consonan t wi th prese,nti~ng reports which areu n d e r s t a n d a b l e a n d w i t h a v o i d i n g d a m a g e t o t h e i r
competitive position. They should also aim to ensure the
integrity and consistency of their reports and they should
meet the spirit as well as the letter of reporting standards.
The Committee wholeheartedly endorses the objectives of
t h e F in a n c i a l R e p o r t i n g C o u n c i l a n d t h e A c c o u n t i n gStandards Board in se t t ing report ing s tandards . I t a lso
welcomes the action being taken by the Financial Reporting
Review Panel over companies who.se accounts fall belowaccepted reporting standards.
The Committee recognises the advantage to users of reports
and accounts of some explanation of the factors likely to
influence their companys future progress. The inclusion
an es sen t ia l ly fo rward- look ing Opera t ing and F inanc ia l
Review, a long the l ines developed by the Account ingStandards Board for consultation, would serve this purpose.
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THE BOARD
Reporting Practice
4.54 Listed companies publish full financial statements annuallyand half-yearly reports in the interim. In between these
m a j o r a n n o u n c e m e n t s , b o a r d s m a y n e e d t o k e e p
shareholders and the market in touch with their companys
progress . The guiding pr inciple once again is openness and
boards should aim for any intervening s tatements to be
widely circulated, in fairness to individual shareholders
and to minimise the possibility of insider trading.
4.55 If companies reported quarterly, the need for more informal
m e t h o d s o f k e e p i n g i n v e s t o r s i n f o r m e d w o u l d b ediminished. Quarterly report ing would, however, involve
addit ional costs for companies and ul t imately for their
sha reholders and has no t been recommended to us by
s h a r e h o l d e r b o d i e s ,4.ho accept the presen t pa t t e rn of reporting by boards.
4.56 We consider that interim reports should be expanded in
order to increase their value to users. We recommend that :
a
b
c
Cd
ba lance sheet in formation should be included wi th theinterim report. There should not be a requirement for a
full audit, but the interim report should be reviewed by
the auditors , who should discuss their f indings with
the audit committee;
the continuing obligat ions laid down by the London
Stock Exchange on UK companies admitted to listing
should be amended to that effect and the Audit ing
Prac t i ces Board should deve lop appropr ia te rev iew
guidance; the Accounting Standards Board in conjunction with
t h e L o n d o n S t o c k E x c h a n g e s h o u l d c l a r i f y . t h e
accounting principles which companies should follow
in preparing interim reports;
a requirement for inclusion of cash flow information in
interim reports should be considered by our successor
body.
4.57Research has shown tha t the mos t wide ly read par t o f
company reports is the opening statement, normally by the
cha i rman. I t i s the re fore of spec ia l impor tance tha t i t
should provide a balanced and readable summary of the
companys performance and prospects and that i t should
represent the collective view of the board.
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THE BOARD
4.58 The demand for an ever- increas ing amount of detai l in
reports and accounts has to be weighed against the need for
them to be unders tandable by the reasonably informed
shareholder . Simpl i f ied forms of repor t , including the
shortened version of the accounts, allow boards to address
shareholders who would prefer such a statement, but make
the need for the assessment to be balanced even more
exacting.
4 .59 Al though a companys publ i shed repor t s and i t s Annual
General Meeting are its primary channels of communication
with shareholders, companies and their major shareholders
may need to be in touch more frequently. The Institutional
Sh a r eh o l d e r s C o mmi t t ee s S t a t emen t o n t h e R esp o n -
s i b i l i t i e s o f I n s t i t u t i o n a l Sh a r eh o l d e r s g i v es p r ac t i ca l
guidance on how shareholders can best exercise thei r
responsibilities as owners in this regard. We fully endorse
their recommendation that there should be regular contact
b e t w e e n c o m p a n i e s a n d t h e i r m a j o r i n s t i t u t i o n a l
shareholders at senior level and that such matters as board
strategy and structure should be kept under review.
Pensions Governance
4.60 There are governance issues relating to company pension
funds, highlighted by the Maxwell affair, but they fall
within the remit of the Pension Law Review Committee
under the chai rmanship of Professor Goode, which i s
c u r r e n t l y r e v i e w i n g t h e f r a m e w o r k o f p e n s i o n f u n d
l e g i s l a t i o n a n d r e g u l a t i o n . I n t h e l i g h t o f t h i s , t h e
Committee decided that it would be inappropriate for it to
deal specifically with pension fund governance issues.
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Importance of Audit
5.1 The annual audit is one of the cornerstones of corporategover nance . G iven the s epa r a t ion o f ow ner sh ip f r om
management, the directors are required to report on their
stewardship by means of the annual report and financial
statements sent to the shareholders. The audit provides an
ex terna l and ob jec t ive c h e c k on the way in which the
financial statements have been prepared and presented, and
it is an essential part of the checks and balances required.
The question is not whether there should be an audit, but
how to ensure its objectivity and effectiveness.
5.2 Audi t s a re a r eassurance to a l l who have a f inancia l
in te res t in companies , qu i te apar t f rom the i r va lue to
boards of directors. The most direct method of ensuring
that companies are accountable for their actions is through
open disclosure by boards and through audits carried out
against strict accounting standards.
5.3 The framework in which auditors operate, however, is not
well designed in certain respects to provide the objectivitywhich shareholders and the public expect of auditors in
c a r r y i n g o u t t h e i r f u n c t i o n . T h e m a i n r e a s o n s a r e a s
follows:
a
b
Accounting standards and practice sometimes allow
boards too much scope for presenting facts and the
f igu r es de r ived f r om them in a va r i e ty o f w ays .
A u d i t o r s c a n n o t s t a n d f i r m a g a i n s t a p a r t i c u l a r
account ing t r ea tment i f i t i s permi t ted wi th in the
standards. A l t h o u g h t h e s h a r e h o l d e r s f o r m a l l y a p p o i n t t h e
auditors, and the audit is carried out in their interests,
the shareholders have no effective say in the audit
negotiation and have no direct link with the auditors.
Indeed the Committee can see no practicable way of
establishing one. Auditors do, however, have to work
closely with those in management who have prepared
the f inancial statements which they are audit ing in
order to carry out their task, and audit firms, like any
o t h e r b u s i n e s s , w i l l w i s h t o h a v e a c o n s t r u c t i v e
relationship with their clients.
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AUDITING
cl
Cd
Audit f i rms are in competi t ion with each other for
business. They wish to maximise their business with
companies, of which auditing may only be a part. To
the extent that they compete on the basis of their
professional reputa tion , this wi ll ac t as an incent ive to
maintain high standards. So will the ethical guidance
of the profession, and the threat of litigation. To the
extent however that audit firms compete on price and
on meeting the needs of their clients (the companies
they audit), this may be at the expense of meeting the
needs of the shareholders.
Companies too are subject to competi t ive pressures.They will wish to minimise their audit costs and they
are likely to have a clear view as to the figures they
w i s h t o s e e p u b l i s h e d , i n o r d e r t o m e e t t h e
expectations of th-eir shareholders.5.4 A fur ther problem is the lack of unders tanding of the
nature and extent of the audi:ors role. This is the so-calledexpectations gap - the difference between what audits doachieve, and what i t i s thought they achieve, or should
a c h i e ve . The e xpe c t a t i ons ga p i s da ma g i ng no t on l ybecause i t reflects unreal ist ic expectat ions of audits but
also because it has led to disenchantment with their value
in the wake of the Capar-o judgment (paragraphs 5.31 to5.35 below).
5.5 Steps have already been taken, within the last three years,
to strengthen the audit system through the establishment of
a new regula tory f ramework. The Financia l Report ing
Counc i l a nd i t s a s s oc i a t e d bod i e s - t h e A c c o u n t i n gStandards Board, the Urgent Issues Task Force, and the
Financial Report ing Review Panel - have been set up toimprove and t ighten accounting s tandards, to deal with
problem areas as they emerge, and to examine departures
by individual companies from the s tatutory requirements
and accounting s tandards. The new statutory regime for
r e gu l a t i ng a ud i t o r s r e qu i r e s a l l a ud i t o r s t o s a t i s fy a
supervisory body as to their competence, experience and
tra ining, and to be subject to regular moni tor ing. The
arrangements for setting auditing standards have also beenreformed with the establishment of the Auditing Practices
Board.
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AUDITING
5.6 The new system has only recently been established and itsfull impact has yet to be felt. In the following paragraphs
we endorse the steps that are being taken and recommend
additional action to strengthen public confidence in the
audit approach.
Professional objectivity
5.7 T h e c e n t r a l i s s u e i s t o e n s u r e t h a t a n a p p r o p r i a t e
r e l a t i o n s h i p e x i s t s b e t w e e n t h e a u d i t o r s a n d t h e
management whose financial statements they are auditing.
Shareholders require auditors to work with and not againstm a n a g e m e n t , w h i l e a l w a y s r e m a i n i n g p r o f e s s i o n a l l y
ob je ct iv e that is to say, applying their professional skills
i m p a r t i a l l y a n d r e t a i n i n g a c r i t i c a l d e t a c h m e n t a n d a
consciousness of their accountability to those who formally
a p p o i n t t h e m . M a i n t a i n i n g s u c h a p r o f e s s i o n a l a n d
objective relationship is the responsibility both of boards
of directors and of auditors, as is that of taking appropriate
action if the basis for that relationship no longer holds.
5.8 An essential f irst step must be the development of more
e f f e c t i v e a c c o u n t i n g s t a n d a r d s . A c c o u n t i n g s t a n d a r d s
provide important reference points against which auditors
exerc ise the i r profess iona l judgement . The i r pos i t ion is
s t r e n g t h e n e d i f s t a n d a r d s d o n o t a l l o w a l t e r n a t i v e
a c c o u n t i n g t r e a t m e n t s . T h e w o r k o f t h e A c c o u n t i n g
Standards Board is well in hand and has our full support.
5.9 A second s tep should be the format ion by every l is ted
company of an audit committee which gives, the auditorsdirect access to the non-executive members of the board.
Shareholders look to the audit committee to ensure that the
relationship between the auditors and management remains
objective and that the auditors are able to put their views
in the event of any difference of opinion with management.
Quarantining audit from other services
5 . 1 0 A m o n g t h e p r o p o s i t i o n s m a d e t o t h e C o m m i t t e e t o
strengthen the objective relationship between auditors and
management, one was that audit firms should not provide
other types of service to their audit clients. The argument
runs that such a prohibition would remove any pressure on
the auditors to give way to management on audit matters in
order not to jeopardise their other business services; and
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AUDITING
that it would remove any incentive for auditors to take on
audits at rates which could risk corner-cutting in the hope
of obtaining more remunerative non-audit work.
5.11 Such a prohibition would limit the freedom of companies to
choose their sources of advice and could increase their
costs. The Committee was not persuaded that any potential
gains in objectivity would outweigh these disadvantages. It
does, however, strongly support full disclosure of fees paid
to audit firms for non-audit work. The essential principle is
that disclosure must enable the relative significance of the
companys audit and non-audit fees to the audit firm to be
assessed, both in a UK context and, where appropriate, aw o r l d w i d e c o n t e x t . W e r e c o m m e n d t ha t t he 1991Regulations under the Companies Act on the disclosure of
remuneration for non-audit work should be reviewed and
amended as necessary in order to apply this principle. We
also regard it as good practice for audit committees to keep
under review the non-audit fees paid to the auditor both in
relation to their significance to the auditor and in relation
to the companys total expenditure on consultancy.
Rotation of auditors
5.12 A not he r p ropos a l w a s t ha t s ome fo rm o f c ompu l s o ry
rotation of audit firms should be introduced, to prevent
relationships between management and auditors becoming
too comfortable. The Committee felt that any advantages
which this could bring would be more than outweighed by
the loss of the trust and experience which are built up when
the re la t ionships are sound, and by the r i sk to audi t
effectiveness at the changeover. The Committee agreed,however, that in the case of listed companies a periodic
change of audit partners should be arranged to bring a fresh
approach to the audit. We recommended in our draft report
that the accountancy profession should draw up appropriate
guidelines and we support the steps which it is now taking
to do so. We would expect the guidel ines to a l low a
measure of flexibility over timing to take account of the
incidence of other changes in senior personnel, both in the
audit team and in the client company, which have helped to
keep a dis t inct ion in re la t ionships between c l ient andauditor.
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AUDITING
Ways to increase effectiveness and value of the audit
The Expectations Gap
5.13 An essential first step is to be clear about the respective
responsibilities of directors and auditors for preparing and
reporting on the financial statements of companies, in order
to begin to narrow the expectations gap.
5.14 T h e a u d i t or s r o le i s t o r e p or t w he t h er t h e fi n a nc i a l
s tatements g ive a t rue and fai r v iew, and the audi t i s
des igned to p r ov ide a r easonab le a s su r ance tha t t hefinancial statements are free of material misstatements. The
a u d i t o r s role is not ( to ci te a few of the misunder-
s tand ings) to p repare the f inancia l s ta tements , nor to
provide absolute assurance that the figures in the financia l
statements are correct, nor to provide a guarantee that the
c om pa ny w i l l c on t i nu e i n ex is te nc e . T h e A ud i t i n g
Practices Board is at present developing proposals for an
expanded report which would describe the key features of
the audit process. The Committee supports this initiative.
A u di t or s r e po r ts s h o ul d s t at e c l e ar l y t he a u d i to r sresponsibilities for reporting on the financial statements, as
a counterpart to a statement of directors responsibilities
for preparing the financial statements (see paragraph 4.28
above).
5.15 T he Commi t t ee s t r ong ly suppo r t s t he l ead w h ich the
Auditing Practices Board is taking on the development of
auditing practice generally. We believe that there should be
an extension of the audit which will add to its value to allusers of accounts and bring it closer into line with public
expecta t ions . We d iscuss be low some of the p roposa ls
currently under consideration and have set out background
infol-mation on the current r ules at Apper~clis 5. W i d e n i n gthe scope of the audit is likely to require boards to widen
the scope of their reports, since auditors can normally only
audi t mat ters on which the directors have themselves
reported.
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Internal Control
5.16T h e C o m m i t t e e i s c o n v i n c e d t h a t a n e f f e c t i v e i n t e r n a l
c o n t r o l s y s t e m i s a n e s s e n t i a l p a r t o f t h e e f f i c i e n t
management of a company. We have already recommended
that d irectors should report on the ef fect iveness of their
system of internal control, and that the auditors should
report on their statement. A great deal of detailed work is
n o w n e c e s s a r y t o d e v e l o p t h e s e p r o p o s a l s , a n d w e
r e c o m m e n d t a t t h e a c c o u n t a n c y p r o f e s s i o n , i nconjunction with representatives of preparers of accounts,
should take the lead in:
(a) developing a set of criteria for assessing effectiveness;
(b ) develop ing gu idance for companies on the form in
which directors should report; and
(c) develop ing gu idance for aud i tors on re levant aud i t
procedures and the form in which audi tors should
report.
5.17 W e r e c o m m e n d t h a t t h e q u e s t i o n othese developments should be dec
experience.
f legislat ion to back
ided i n t h e l i g h t o f
Going Concern
5.16 U n d e r c o m p a n y l a w , a cc ou nt s a r e p re pa re d o n t heassumption that the company is a going concern. There is,
however, no expl ici t requirement for d irectors to sat isfy
themselves that it is reasonable to make this assumption,
for example by the preparat-ion of an adequate cash flow
f o r e c a s t . T h e r e i s a l s o s c o p e f o r a m e n d i n g a u d i t i n gguidelines to require the auditor to take a more active role
in testing going concern assumptions.
5.19 In view of the understandable public criticism of the auditp r o c e s s w h e n c o m p a n i e s c o l l a p s e w i t h o u t a p p a r e n t
warn ing, there are strong arguments for amending company
law to place an explicit requirement on directors to satisfy
themselves that the going concern basis is appropriate, and
t o r ep o r t a c c or d i ng l y to s h ar e h ol d e rs . T he re i s a ls o a
strong case for extending the scope of the audit, to testg o i n g c o n c e r n a s s u m p t i o n s m o r e s p e c i f i c a l l y , a n d f o r
requiring the auditors to give an opinion on the directors
report. Many proposals have been made to the Committee
along these lines.
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A U D I T I N G
5.20 The Commit tee be l ieves tha t going concern problemsm o r e l i k e l y t o b e a d d r e s s e d s u c c e s s f u l l y i f t h e y
iden t i f ied ear ly . There a re , however , two grounds
concern:
(a) There must be a risk that any qualification about
are
a r e
f o r
the
companys financial viability, however it is expressed,
will precipitate the companys collapse. There is a fine
ba lance to be drawn be tween drawing proper attent ion
to the conditions on which continuation of the business
depends, and not thereby bringing the business down.
(b) The Committee does not believe that the implications
of the legal presumption that the accounts are preparedon a going concern basis are widely understood by
directors. In particular the Committee doubts that it is
g e n e r a l l y a p p r e c i a t e d t h a t g o i n g c o n c e r n i s
interpreted in present auditing guidelines as meaning
that the company will s t i l l be operating six months
following the date of the audit report or one year after
the date of the balance sheet, whichever is the later.
This may be further ahead than many companies can
see, for example in a recession.
5.21 The Committee concludes that as a fundamental concept of
a c c o u n t i n g t h e g o i n g c o n c e r n p r i n c i p l e s h o u l d b e
conscientiously applied and that new guidelines should be
developed. It emphasises however that new guidelines must
strike a careful balance between drawing proper attention
to the conditions on which the continuation of the business
d e p e n d s , a n d n o t r e q u i r i n g d i r e c t o r s t o e x p r e s s
u n n e c e s s a r i l y c a u t i ou s r e s e r va t i o n s t h a t c o u l d o f
themselves jeopardise the business. Directors should be
required to satisfy themselves that the business is a going
c o n c e r n o n t h e b a s i s t h a t t h e y h a v e a r e a s o n a b l e
expecta t ion that it will continue in operation for the time
period which the guidelines d,efine. Directors should not beexpected to give a firm guarantee about their companys
prospects because there can never be complete certainty
about future trading. The guidelines should also recognise
the position of smaller companies.
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AUDITING
5.22
Fraud
5.23
5.24
5.25
5.26
The
(a)
(b)
(c)
(d)
Committee recommends that:
directors should state in the report and accounts that
t he bus i ne s s i s a go i ng c onc e rn , w i t h s uppor t i ngassumptions or qualifications as necessary;
the auditors should report on this statement;
t h e a c c o u n t a n c y p r o f e s s i o n i n c o n j u n c t i o n w i t h
representat ives of preparers of accounts should take
the lead in developing guidance for companies and
auditors;
the question of Legislation should be decided in the
light of experience.
The prime responsibility for the prevention and detection
of fraud (and other illegal acts) is that of the board, as part
of its fiduciary responsibility for protecting the assets of
the company. The auditors responsibi l i ty, as defined in
a ud i t i ng gu i da nc e , i s p r o p e r l y t o p l a n , p e r f o r m a n d
e va l ua t e h i s a ud i t w ork s o asi h a v e a r e a s o n a b l eexpecta t ion of detect ing mater ia l miss ta tements in thefinancial statements.
One problem for the auditors is that by i ts very nature
f raud , i f i t i nvolves forgery , co l lus ion or management
over r ide of cont ro l sys tems , is hard to detect. It is no
solution, as some have suggested, simply to place a duty on
the auditor to detect material fraud because he will never
be in a pos it ion to guarantee that no such fraud has taken
place. A higher level of safeguard agains t some categories
of fraud can be attempted by carrying out a more extensiveaudit, but at a cost. The question is whether that extra cost
is justified.
Another problem for the auditors is when they suspect that
top management itself is implicated in the fraud, without
having the necessary evidence to back up their suspicions.
They a re no t in a s t rong enough pos i t ion to conf ront
m a n a g e m e n t , no r ha ve t he y a c a s e t o r e po r t t o t he
appropriate authorities.
These are not easy problems to resolve, but an effective
and independent-minded audit committee is an essential
safeguard. It has an important role to play in considering
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AUDITINGwhether any extra work should be undertaken in addition to
the normal audit procedures to investigate defences against
fraud. and in reviewing reports on the adequacy of internal
contol syste
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